Leading liquid alternative fund categories include equity long/short strategies, event-driven strategies, relative value strategies, tactical trading/macro strategies and multi-strategy approaches. If interest rates rise, and possibly end the current bull market, many investors would like to know which of these categories are poised to deliver the best risk-adjusted returns in coming quarters.

That’s the wrong way to look at it, according to Larry Restieri, the chief operating officer for Goldman Sachs Asset Management’s third-party distribution business in the U.S. “It’s very hard to predict which subsector will be the top performer in the near term,” he says. Instead, “you need to have a long-term strategic approach with these funds and not just trade them for the next six to 12 months.”

That view is shared by Morningstar’s John Rekenthaler. He looked at the fund flows for various liquid alterative investment categories over the past seven years, and the results “show fund investors chasing the hot investment categories, always arriving after the good news.” Invariably, such bad timing leads to subsequent underperformance, which can sour investors on the virtues of these strategies.

Instead, investors should focus on high-quality funds and accept the fact that, as a portfolio hedge, they play a long-term role, not a short-term one. How to find the best funds? The key to success with liquid alts is to find managers with deep experience in their strategies but who also have experience running a mutual fund, says Nadia Papagiannis, the director of alternative investment strategy for global third-party distribution at Goldman Sachs Asset Management.
She believes that many hedge fund managers aren’t always well-suited to handle the complexities of mutual fund regulations, as spelled out by the Investment Company Act of 1940.

To be sure, it can be very time-consuming to research and identify an ideal manager for each of the liquid alternative subcategories an investor chooses to pursue. That’s why Goldman Sachs’s Restieri and Papagiannis think it’s wiser to consider funds that glean exposure to multiple strategies and the expertise of multiple fund managers.

One key drawback: “Funds that employ multiple managers to run separately managed accounts tend to be the most expensive in the category, with expense ratios well north of 2%,” wrote Morningstar’s Jason Kephart in a note to clients.

That may explain why Morningstar fails to anoint any of these funds with “Gold” or “Silver” medals, although seven of them have garnered “Bronze” stars. Of these funds, the MFS Global Alternative Strategy I Fund (DVRIX) has delivered a category-leading 6.9% annualized return over the past three years (at least among the seven funds that are Morningstar medalists). The fund’s 1.15% expense ratio is among the lowest in the category.

If you look into the crystal ball, you may see a stock market that is still rising in six to nine months. Bonds, for that matter, may also muddle along in a benign fashion. “The path of least resistance is to continue in the same direction,” notes Morton Capital’s Sarti. Yet he and many other market watchers know that troubles lurk beneath the surface.

In effect, market performance has become decoupled from economic performance. As far as Sarti is concerned, “the imbalances will only become more extreme.” That backdrop makes this a good time to boost your exposure to alternative investments. They may not be poised to deliver sharp gains, but they appear to be quite well-suited to the goal of capital preservation. 
 

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